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Three Models of Corporate Governance January 2009
Three Models of Corporate Governance January 2009
The corporate governance structure of joint stock corporations in a given country is determined by several factors: the legal and regulatory framework outlining the rights and responsibilities of all parties involved in corporate governance; the de facto realities of the corporate environment in the country; and each corporations articles of association. While corporate governance provisions may differ from corporation to corporation, many de facto and de jure factors affect corporations in a similar way. Therefore, it is possible to outline a "model" of corporate governance for a given country. In each country, the corporate governance structure has certain characteristics or constituent elements, which distinguish it from structures in other countries. To date, researchers have identified three models of corporate governance in developed capital markets. These are the Anglo-US model, the Japanese model, and the German model. Each model identifies the following constituent elements: key players in the corporate environment; the share ownership pattern in the given country; the composition of the board of directors (or boards, in the German model); the regulatory framework; disclosure requirements for publicly-listed stock corporations; corporate actions requiring shareholder approval; and interaction among key players. The purpose of this article is to introduce each model, describe the constituent elements of each and demonstrate how each developed in response to country-specific factors and conditions. Readers should understand that it is not possible to simply select a model and apply it to a given country. Instead, the process is dynamic: the corporate governance structure in each country develops in response to country-specific factors and conditions.
The Anglo-US model governs corporations in the UK, the US, Australia, Canada, New Zealand and several other countries. EWMI/PFS Program / Lectures on Corporate Governance - Three Models of Corporate Governance December2005.doc 1
The Anglo-US model, developed within the context of the free market economy, assumes the separation of ownership and control in most publicly-held corporations. This important legal distinction serves a valuable business and social purpose: investors contribute capital and maintain ownership in the enterprise, while generally avoiding legal liability for the acts of the corporation. Investors avoid legal liability by ceding to management control of the corporation, and paying management for acting as their agent by undertaking the affairs of the corporation. The cost of this separation of ownership and control is defined as agency costs. The interests of shareholders and management may not always coincide. Laws governing corporations in countries using the Anglo-US model attempt to reconcile this conflict in several ways. Most importantly, they prescribe the election of a board of directors by shareholders and require that boards act as fiduciaries for shareholders interests by overseeing management on behalf of shareholders. Two diagrams at the end of this article explain the dynamics of the Anglo-US model in theory and in practice.
The term capital market is broad, encompassing all the markets where stocks (also known as shares), bonds, futures, derivatives and other financial instruments are traded. Securities market is more specific, referring to stocks and bonds. Equity market is most specific, referring only to stock, also known as equity. EWMI/PFS Program / Lectures on Corporate Governance - Three Models of Corporate Governance December2005.doc 2
Board composition and board representation remain important shareholder concerns of shareholders in the UK and US. Perhaps this is because other corporate governance issues, such as disclosure and mechanisms for communication between corporations and shareholders, have largely been resolved. UK and US boards are generally smaller than boards in Japan and Germany. In 1993, a survey of the boards of the 100 largest US corporations conducted by the executive search firm Spencer Stuart found that boards were shrinking slightly; the average size was 13, compared with 15 in 1988.
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including background information an all proposals ("proxy statement"), the corporations annual report and a voting card. Shareholders may vote by proxy, that is, they complete the voting card and return it by mail to the corporation. By mailing the voting card back to the corporation, the shareholder authorizes the chairman of the board of directors to act as his proxy and cast his votes as indicated on the voting card. In the Anglo-US model, a wide range of institutional investors and financial specialists monitor a corporation's performance and corporate governance. These include: a variety of specialized investment funds (for example, index funds or funds that target specific industries); venture-capital funds, or funds that invest in new or "start-up" corporations; rating agencies; auditors; and funds that target investment in bankrupt or problem corporations. See the diagram "Diversified Monitoring in Anglo-US Corporate Governance" for a pictoral explanation of this phenomenon. In contrast, one bank serves many of these (and other) functions in the Japanese and German models. As a result, one important element of both of these models is the strong relationship between a corporation and its main bank.
See Bergloef, Eric, 1993. Corporate Governance in Transition Economies: The Theory and its Policy Implications. in Masahiko Aoki and Hyung-Ki Kim, editors, Corporate Governance in Transitional Economies: Insider Control and the Role of Banks. Washington, D.C.: The World Bank. EWMI/PFS Program / Lectures on Corporate Governance - Three Models of Corporate Governance December2005.doc 6
Many Japanese corporations also have strong financial relationships with a network of affiliated companies. These networks, characterized by crossholdings of debt and equity, trading of goods and services, and informal business contacts, are known as keiretsu. Government-directed industrial policy also plays a key role in Japanese governance. Since the 1930s, the Japanese government has pursued an active industrial policy designed to assist Japanese corporations. This policy includes official and unofficial representation on corporate boards, when a corporation faces financial difficulty. In the Japanese model, the four key players are: main bank (a major inside shareholder), affiliated company or keiretsu (a major inside shareholder), management and the government. Note that the interaction among these players serves to link relationships rather than balance powers, as in the case in the Anglo-US model. In contrast with the Anglo-US model, non-affiliated shareholders have little or no voice in Japanese governance. As a result, there are few truly independent directors, that is, directors representing outside shareholders. The Japanese model may be diagrammed as an open-ended hexagon:
The base of the figure, with four connecting lines, represents the linked interests of the four key players: government, management, bank and keiretsu. The open lines at the top represent the nonlinked interests of non-affiliated shareholders and outside directors, because these play an insignificant role.
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The board of directors of Japanese corporations is composed almost completely of insiders, that is, executive managers, usually the heads of major divisions of the company and its central administrative body. If a companys profits fall over an extended period, the main bank and members of the keiretsu may remove directors and appoint their own candidates to the companys board. Another practice common in Japan is the appointment of retiring government bureaucrats to corporate boards; for example, the Ministry of Finance may appoint a retiring official to a banks board. In the Japanese model the composition of the board of directors is conditional upon the corporations financial performance. A diagram of the Japanese model at the end of this article provides a pictorial explanation. Note the relationship between the share ownership structure and the composition of Japanese boards. In contrast with the Anglo-US model, representatives of unaffiliated shareholders (that is, outsiders) seldom sit on Japanese boards. Japanese boards are generally larger than boards in the UK, the US and Germany. The average Japanese board contains 50 members.
restructurings; proposed amendments to the articles of association; and names of individuals and/or companies proposed as auditors. Japans disclosure regime differs from the US regime (generally considered the worlds strictest) in several notable ways. These include: semi-annual disclosure of financial data, compared with quarterly disclosure in the US; aggregate disclosure of executive and board compensation, compared with individual data on the executive compensation in the US; disclosure of the corporations ten largest shareholders, compared with the US requirement to disclose all shareholders holding more than five percent of the corporations total share capital; and significant differences between Japanese accounting standards and US Generally Accepted Accounting Practices (US GAAP).
The German corporate governance model differs significantly from both the Anglo-US and the Japanese model, although some of its elements resemble the Japanese model. Banks hold long-term stakes in German corporations6, and, as in Japan, bank representatives are elected to German boards. However, this representation is constant, unlike the situation in Japan where bank representatives were elected to a corporate board only in times of financial distress. Germanys three largest universal banks (banks that provide a multiplicity of services) play a major role; in some parts of the country, public-sector banks are also key shareholders. There are three unique elements of the German model that distinguish it from the other models outlined in this article. Two of these elements pertain to board composition and one concerns shareholders rights: First, the German model prescribes two boards with separate members. German corporations have a two-tiered board structure consisting of a management board (composed entirely of insiders, that is, executives of the corporation) and a supervisory board (composed of labor/employee representatives and shareholder representatives). The two boards are completely distinct; no one may serve simultaneously on a corporations management board and supervisory board. Second, the size of the supervisory board is set by law and cannot be changed by shareholders. Third, in Germany and other countries following this model, voting right restrictions are legal; these limit a shareholder to voting a certain percentage of the corporations total share capital, regardless of share ownership position.7 Most German corporations have traditionally preferred bank financing over equity financing. As a result, German stock market capitalization is small in relation to the size of the German economy. Furthermore, the level of individual stock ownership in Germany is low, reflecting Germans conservative investment strategy. It is not surprising therefore, that the corporate governance structure is geared towards preserving relationships between the key players, notably banks and corporations. The system is somewhat ambivalent towards minority shareholders, allowing them scope for interaction by permitting shareholder proposals, but also permitting companies to impose voting rights restrictions. The percentage of foreign ownership of German equity is significant; in 1990, it was 19 percent. This factor is slowly beginning to affect the German model, as foreign investors from inside and outside the European Union begin to advocate for their interests. The globalization of capital markets is also forcing German corporations to change their ways. When Daimler-Benz AG decided to list its shares on the NYSE in 1993, it was forced to adopt US GAAP. These accounting principles provide much greater financial transparency than German accounting standards. Specifically, Daimler-Benz AG was forced to account for huge losses that it could have hidden under German accounting rules.
The German term for joint stock corporation is Aktiengesellschaft; German and Austrian corporations use the abbreviation AG following their name, for example, Volkswagen AG. 7 In 1994, some 10 major German banks and corporations still had voting rights restrictions, although the recent trend in European Union (EU) countries has been to repeal them. EWMI/PFS Program / Lectures on Corporate Governance - Three Models of Corporate Governance December2005.doc 10
bank) and voting agent at AGMs. In 1990, the three largest German banks (Deutsche Bank AG, Dresdner Bank AG and Commerzbank AG) held seats on the supervisory boards of 85 of the 100 largest German corporations. In Germany, corporations are also shareholders, sometimes holding long-term stakes in other corporations, even where there is no industrial or commercial affiliation between the two. This is somewhat similar, but not parallel, to the Japanese model, yet very different from the Anglo-US model where neither banks nor corporations are key institutional investors. The mandatory inclusion of labor/employee representatives on larger German supervisory boards further distinguishes the German model from both the Anglo-US and Japanese models.
Composition of the Management Board (Vorstand) and Supervisory Board (Aufsichtsrat) in the German Model
The two-tiered board structure is a unique construction of the German model. German corporations are governed by a supervisory board and a management board. The supervisory board appoints and dismisses the management board, approves major management decisions; and advises the management board. The supervisory board usually meets once a month. A corporations articles of association sets the financial threshold of corporate acts requiring supervisory board approval. The management board is responsible for daily management of the company. The management board is composed solely of insiders, or executives. The supervisory board contains no insiders, it is composed of labor/employee representatives and shareholder representatives. The Industrial Democracy Act and the Law on Employee Co-determination regulate the size and determine the composition of the supervisory board; they stipulate the number of members elected by labor/employees and the number elected by shareholders. The numbers of members of the supervisory board is set by law. In small corporations (with less than 500 employees), shareholders elect the entire supervisory board. In medium-size corporations (defined by assets and number of employees) employees elect one-third of a ninemember supervisory board. In larger corporations, employees elect one-half of a 20-member supervisory board. Note these two key differences between the German model and the other two models. First, the size of the supervisory board is set by law and cannot be changed. Second, the supervisory board includes labor/employee representatives. While the supervisory board includes no insiders, it does not necessarily include only outsiders. The members of the supervisory board elected by shareholders are usually representatives of banks and corporations which are substantial shareholders. It would be more appropriate to define some of these as affiliated outsiders.
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For a pictorial explanation of board composition in the German model, please refer to the diagram of the German model at the end of this article.
In contrast with the Anglo-US and the Japanese models, shareholders do not possess the authority to alter the size or composition of the supervisory board. These are determined by law. Other common corporate actions which also require shareholder approval include capital authorizations (which automatically recognize preemptive rights, unless revoked by shareholder approval); affiliation agreements with subsidiaries; amendments to the articles of association and/or charter (for example, a change of approved business activities); and increase of the aggregate compensation ceiling for the supervisory board. Non-routine corporate actions which also require shareholder approval include mergers, takeovers and restructurings. Shareholder proposals are common in Germany. Following announcement of the agenda for the meeting, shareholders may submit in writing two types of proposals. A shareholder counterproposal opposes the proposal made by the management board and/or supervisory board in an existing agenda item and presents an alternative. For example, a counterproposal would suggest a dividend higher or lower than that proposed by the management board, or an alternative nominee to the supervisory board. A shareholder proposal requests the addition of an issue not included on the original agenda. Examples of shareholder proposals include: alternate nominees to the supervisory board; authorization of a special investigation or audit; suggestions to abolish voting rights restrictions; and recommendations for changes to the capital structure. Provided that such proposals meet legal requirements, the corporation is required to publish these shareholder proposals in an amended agenda and forward them to shareholders prior to the meeting.
potential conflict of interest between the bank and the beneficial shareholder. It also increases the potential voting power of the bank, because some shareholders might not provide specific voting instructions and the bank may exercise the votes according to its interpretation. Because the level of individual share ownership in Germany is very low, this is not a huge problem. Nevertheless, it reflects a certain pro-bank and anti-shareholder tendency of the system. Other obstacles to shareholder participation include the above-mentioned legality of voting right restrictions, and the fact that shareholders may not vote by mail. As noted above, shareholders must either attend the meeting in person or to be represented in person, i.e., by their custodian bank. Despite these obstacles, minority German shareholders are not inactive. In fact, they often oppose management proposals and present a wide range of counterproposals and proposals at the AGMs and EGMs of many German corporations each year. In Austria, minority shareholders are less active, perhaps because the Austrian government is, directly or indirectly, a large shareholder in many companies.
Conclusion
The article has introduced each model, describe the constituent elements of each and demonstrate how each developed in response to country-specific factors and conditions. It should reflect the fact that it is not possible to simply select a model and apply it to a given country. Instead, the process is dynamic: the corporate governance structure in each country develops in response to country-specific factors and conditions. With the globalization of capital markets, each of these three models is opening (albeit slowly) to influences from other models, while largely retaining its unique characteristics. Legal, economic and financial specialists around the world can profit from a familiarity with each model.
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